Construction Shares: For the brave
The sharp run-up in the share prices of SA construction companies this year has made the construction sector the place to be in 2006, but to capture further potential gains in the new year one will have to be a brave investor, according to Feroz Basa, equity analyst at Old Mutual Asset Managers (OMAM).
So far in 2006, construction company counters have gained between 70% and 100%, significantly outperforming every other JSE-listed share, not to mention the FTSE/JSE All Share Index, which was up 31% to end-November. Had you bought Murray & Roberts at the beginning of the year, you would have benefited from a 93% increase in the share, while Aveng is up 79%, Group Five is 88% higher and WBO has risen 65%.
"The irony is that many analysts, including myself, thought that these shares were already fully valued at the beginning of the year, but yet we've seen these steep prices rise anyway, and they look like they are going higher, mostly on sheer hype," says Basa. "Normally construction shares trade at around a 20% discount to the FTSE/JSE Industrial Index because of the risk associated with their large projects, but currently they are trading at premiums of 20-30% - this illustrates how high the prices are on a historical basis."
He points out that, although fundamentally the four companies' medium-term earnings growth is strongly underpinned by record order books, their current share prices imply that nothing will go wrong with any of their big upcoming projects.
"There is no room for error. If one of these companies has even one large contract that somehow goes wrong, we could see a sharp reaction in its share price. on the other hand, early next year we will be hearing who wins major construction contracts including the three new World Cup soccer stadiums and King Shaka Airport in Durban, and in re action, the share prices could rise even further."
As a result, Basa cautions, investors holding the shares should keep a close eye on them and be ready for a jittery 2007. To sell them would be a difficult decision, however, as fundamentals for the SA construction sector have never been better.
"The sector is benefiting from a confluence in strong infrastructure spending by both the private sector and government, but the government spending is only just beginning," the analyst explains. "There is now a huge amount of money being poured into so many large projects across retail, commercial and industrial property and government's mega-projects linked to the 2010 World Cup, Eskom, Transnet and other big infrastructure upgrades, that construction companies have all the work they can handle."
And with a limited number of companies and resources to do the work, they are able to command higher margins, thus further boosting their earnings, he notes. Although there has been some competition from Chinese companies - which have generally tendered about 25% cheaper than their local counterparts - most of these have not yet established their reputations in the market and are finding it difficult to compete on factors other than price.
"Another development that has caught some analysts and the market by surprise has been the exceptionally strong performances of the construction companies' materials businesses, supplying steel, bricks, pipes and other materials for construction," Basa adds. "In 2006 these businesses have been the strongest earnings drivers. For example, this year Aveng's Trident Steel and Murray & Roberts' Hall Longmore & Genrec recorded growth of 45% and 30%, respectively. one forgets that, up until the end of 2005, the construction divisions of Murray & Roberts and Aveng actually posted losses in South Africa."
Looking ahead, Basa says he expects 2007 and 2008 to be the real "crunch time" for the local construction industry as many of the go vernment's mega-projects get underway ahead of the 2010 deadline, not to mention the numerous new power stations costing R20bn each and R60bn of Transnet spending. Meanwhile, the private sector will continue to spend with projects like the R22bn mini-city Waterfall Development in Johannesburg and the proposed US$1bn V&A Waterfront upgrades in Cape Town, amongst many others.
"The government is really only starting its infrastructure spending now, yet the construction companies have already recorded earnings growth of between 20-50% so far this year and they are expecting further increases of 50-60% for the six months to end-December, according to their own earnings updates. Their earnings from government projects have yet to make an impact on their top lines.
"So earnings growth for the industry as a whole is underpinned by excellent fundamental factors - it's just a question of how much higher the share prices can go as a result. Those investors already in the market will have to brace themselves for a nervous 2007, and I would advise conservative investors not to buy construction shares at current price levels," concludes Basa.
